101: Introduction to Financials (Ep.3)

Understand what a company is telling you. (Yes we know it can be boring, but could make you better off in the long-term.)

Ok, so now that you’re considering starting your investment journey, we would like to introduce you to the ‘language of business’, so to speak.

Organisations do communicate to us, they tell us whether they’re healthy and doing well, or if they’re not so healthy and could be actually going through a struggle. 
The only way you’ll actually know the health of an organisation is by going through an organisations financial statements. Although numbers may not be your cup of tea, it’s important that you start understanding what an organisation is telling you.

There are three main financial statements, these being:

The Balance sheet;
The Profit or loss; and 
The Cash flow statement.

Where can I find these reports? 
These statements can be found in the investor relations page on any listed company’s website under the headings :10K for annual reports, and 10Q for quarterly reports.

The Balance sheet

In short, a balance sheet represents what an organisation is essentially worth on paper, if the company where to be sold today. 
The Balance Sheet is made up of Assets, Liabilities and Equity (Capital).

Assets can be spilt between the short-term assets and long-term assets. Short term (current) assets represent amounts which an organisation is expecting to receive within a period of time that does not exceed 12 months (short-term).
Let’s take Apple as an example.
We all know what apple does, it produces Iphones and other electronic goods. These goods aren’t all sold when they are produced, but rather they are shelved within warehouses or Stores. From these goods, Apple expects to sell them within 12 months, and generate an income within that time.

In addition to this, amounts held in cash and other short-term investments generally stand to be classified as a short-term asset.

Long-term (Non-current) assets. These assets are held by an organisation for the long term, which is longer than 12 months.

These tend to consist of factories, property plant and equipment, and one way or another contribute to the income generated by an organisation.
For example, Ford require their factories and their heavy machinery to build cars, and subsequently sell the final product to generate an income.

Like assets, liabilities can be recognised both in the long-term and the short term. 
Short term (current) liabilities can be described as a future obligation (expense) that an organisation needs to overcome in a period that is within a 12 month bracket. 
So, for example, an organisation needs to pay a supplier for goods it purchased within the next 12 months.

On the other hand, a long term (Non-current) liability can be simply described as an obligation (expense) that an organisation would need to pay in a period that is greater than 12 months, hence are long-term. An example of this would be repayments on a 20 year loan.

If an organisation where to be bought today on paper, the value of the organisation would be represented as equity. As such, if all the assets were sold and all the liabilities paid, what we would be left with is equity (the value of a company).

Despite the value of an organisation being represented as equity, sometimes another organisation would be willing to pay more than the ‘equity value’ to acquire an organisation, as it would be believed that the acquisition would add some real long-term value to a business. This is referred to Goodwill, and we’ll refer to the buzzword later on.

Total assets — Total liabilities = Equity (capital).

Profit or Loss

The title of this statement is pretty explanatory. Is the Organisation generating a profit or a loss?

The main areas that you should be focusing include:

This represents the amount an organisation generates through the sale of a product or a service. Generally speaking, the higher the growth percentage (%) an organisation incurs, the better. You’ll be able to determine this by comparing the increase in revenue from previous years.

Cost of sales
Cost of sales represents the amount of direct costs an organisation would incur to generate a product or a service that will eventually be sold to customers. 
Let’s take apple as an example again. To produce an Iphone, apple would require raw materials, and labour to piece together the final product. These costs are essential to produce a product or a service.

Gross profit or Gross loss
Is the amount an organisation would be left with after subtracting the revenue from the cost of sales.

Revenue (sales) — Cost of sales = Gross profit

As an investor you are going to want to keep an eye on this figure and understand whether or not this amount has increased or decreased, and understand why. 
Another important buzz word that you’re going to have to keep in mind is the gross profit margin % = (Gross profit/sales) x 100. We’ll be covering this and other metrics in future write ups.

Operating expenses 
In simplistic terms, these represent the indirect expenses an organisation would incur to run its operations, so for example the administrative expenses and sales and marketing costs that are not directly tied to the production of a good or a service.

Everyone has to pay them, and there really isn’t much to explain here, so we decided to let you use your own imagination.

Net profit or Net loss 
This amount is the final figure of the statement of profit and loss, and determines whether or not the organisation is a profitable entity or a loss making entity. 
(Gross profit/loss – Operating expenses – taxation = Net loss/profit)

As such it is important to note that even though an organisation is a loss making company, this does not necessarily mean that its a bad investment, but be cautious and understand where the organisation is in its life-cycle.
Is it it in the growth stage or in the value stage?

If an organisation is in its growth stages, it is normal to see an organisation at a loss, simply because its probably really investing in sales and marketing costs and research and development to extend its reach. 
But don’t worry about this just yet though, we’ll be releasing an article covering the key differences between a growth and value stocks, in the future.

Statement of Cash flows

The statement of cash flow essentially highlights where the organisations cash is being made and spent. But just to give you a brief overview, the cashflow is split into the following areas:

  • Cash flow generated from operations 
    This as such highlights the amount of cash that an organisation generates from its trading activity. If the final figure is negative, then there was a final cash outflow generated from operations, whilst if it is positive, then this represents a cash inflow.
  • Cash flow used in investing 
    This represent the amount of money invested in capital expenditure, this generally includes, the acquisition of machinery or property and would fall under this section of the cashflow. From this investment, the company in question would be expecting to generate future cash. 
    If you are observing this section of the cashflow statement, then a negative figure would generally represent the acquisition of a long-term asset (example machinery), whereas a positive figure would represent the sale of a capital good, as cash would be coming in through the sale.
  • Cash flow from financing activities
    Financing activities tend to be an organisations acquisition of finance (money), so this tends to refer to the funds raised by taking on a loan, or perhaps raising funds through issuing shares on a stock exchange.

When assessing a cashflow statement, its important you understand these metrics, and understand where an organisation is spending/receiving its cash from.

Investors should start to ask the following questions when

-Where has the organisations cash come from? 
– Is it acquiring more assets? and if so what has it acquired and why?
– Why has it entered into a new loan agreement(s)?
– Is the organisation really dependent on loan finance to fund its operations?
– Is the organisation generating cash? Or is it burning through cash like no tomorrow?

To Wrap it all up

If you made it thus far to the article, congratulations! This article may have been the least exciting article we have ever written, but is an essential part of investing that all investors need to be aware of. We will guide you through this process in more detail in following content. ‘kollox pas pas’…

The Financial statements are essentially a means of communication from a business’s end to its stakeholders, (in this case, you and I). As investors we want to ensure that we have a decent understanding of this, so that if there’s ever a crash in share prices, we can sleep well at night knowing that our investments are going to be just fine in the longer-term.

If you’re interested in joining us on our journey, join our Facebook group: The Investment Hub — Malta

Any views or opinions presented in this article are personal and shouldn’t be taken/used as professional advice as we are not qualified financial advisors.
Any statistics mentioned have all been linked to their respective documents together with their ownership.
Lastly, we would like to note that this article has no tie to our professional jobs and was conducted in our free time.